The Problems of Transfer Pricing

I ts hard enough for a company to do business when its situated in only one state, but consider the complexities when it adds facilities in another stateor, even worse, when it goes international. In addition to having to prepare multiple tax filings, a business with far-flung facilities suddenly must contend with another complication: transfer pricingin which local tax authorities view a company division in one political venue as a customer and/or a supplier of a related division in another political venue. The upshot is that the cost of any goods or services the two units exchange must be determined when the company calculates each units tax liability.

This article examines the processincluding its tax, accounting and corporate profit implications.

If you think transfer pricing affects only big companies, think again. Size is immaterial. The only condition that triggers transfer pricing is the existence of multiple facilities in more than one taxing jurisdiction. For example, a company with 45 employees in five locations in two states would activate transfer pricing concerns if one of its offices provides data processing, payroll or other services to the others. Similar situations arise in manufacturing, when one division ships parts or unfinished products for final assembly at another location in a different jurisdiction.

A key element is a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit. Companies establish transfer prices in a variety of ways. Two of the most popular are by estimating competitive market prices and by adding a markup to costs.

To illustrate, look at Example, Inc., a producer of telephones and related equipment at its Alpha division, which is situated in an urban U.S. community with high taxes on property and income. Competitive pressures combined with those high taxes prompted Alpha to look for lower tax jurisdictions for expansion. An opportunity arose when a supplier offered to sell its entire operation. The supplier has two facilities: one, Beta, is in a state with no income tax; and the other, Gamma, is in Canada, near the U.S. border.

Beta produces a variety of molded plastic parts, including the hard-plastic exteriors or shells of telephones, using raw plastic purchased in bulk. Excluding shells, much of Betas output is shipped to Gamma, where it is combined with purchased parts to create telephone subassemblies. As a result of the planned acquisition, Example will produce shells at Beta for sale to unaffiliated or outside entities and also will produce shells for its own use in final assembly at Alpha and for subassemblies at Gamma; some of these subassemblies will be shipped from Gamma to Alpha for final assembly. In addition, Alpha will provide marketing and administrative services for all three locations.

TAX CONSIDERATIONS
A danger that Example will want to avoid is being whipsawed between the taxing authorities of two jurisdictionsthat is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules. Further, because Alpha is in a high-tax state, any transfer pricing system that shifts taxable income away from Alpha will probably be challenged almost automatically by the state in which Alpha is situated.

In most states, companies compute taxable income using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.

Generally, its to the taxpayers advantage to establish high transfer prices for goods and services provided by a unit in a jurisdiction with low tax rates. The result is to have more revenue subjected to a lower rate and less to a higher rate. If the operating unit receiving the goods and services is in a high-rate jurisdiction, the high transfer price also produces a large expense deduction for that division. When goods and services must flow in the opposite directionfrom high- to low-tax jurisdiction, its better for the transfer price to be set as low as possible. Of course, tax authorities usually have a different interest: They want to maximize tax revenues.

In the illustration, suppose Beta produces plastic parts at a cost of $10,000 and ships them to Gamma, which processes them further at an additional cost of US$1,000 and then ships them to a nonaffiliated Canadian customer, which pays Alpha a total of US$20,000 for them. A transfer pricing mechanism will attribute some of the $9,000 profit to each unit and to the tax return for each country.

Now suppose Example assigns a transfer price of $17,000, resulting in Canadian taxable income equivalent to US$2,000 and taxable income from U.S. sources of $7,000. If the U.S. authorities reject Examples transfer prices, they may tax the entire $9,000 profit even though Canadian income tax also is paid on the Canadian portion. The result is double taxation on $2,000 of income.

A similar problem can arise if Example later changes its transfer pricing system. The prospective loss of tax revenue may lead one jurisdiction to reject the new system, while a prospective increase in taxes may lead the other jurisdiction to leave the new system in place. The key is not simply to set individual transfer prices at the right level but to have a defensible system in place for setting transfer prices and to make sure that that system wins government approval in all tax jurisdictions. CPAs should be aware that some national taxing authorities, including the IRS, will examine and may approve a taxpayers proposed transfer pricing method in advance, thus removing the uncertainty.

A business wishing to reduce the uncertainty concerning IRS approval of its transfer pricing method can participate in the IRS advance pricing agreement (APA) program, as set out in revenue procedure 96-53 (1996-2 CB 375). More than 100 businesses have secured protection under this program. In Notice 98-10 (1998-6 IRB), the IRS announced plans to institute special APA procedures for small businesses.

A critical issue is establishing a transfer price for marketing and administration services. Assuming Alpha charges Beta and Gamma a low price (in relation to what Alpha incurs to provide those services) for marketing and administration services, taxable income effectively would shift away from Alphas high-tax jurisdiction and to Betas and Gammas low-tax jurisdictions. Thus, if Alpha received a transfer price of $80,000 ($40,000 each from Beta and Gamma) for marketing and administration services that cost $100,000 to provide, Alphas income would be reduced by the $20,000 difference. Correspondingly, Betas and Gammas income would be $20,000 higher because they are paying only $80,000 as opposed to the full $100,000 that Alpha incurs to provide the services. To be sure, the company would have to justify that price.

Suppose Example faces effective income tax ratesstate, local and federal combinedof 52% in the Alpha location, 39.6% in Beta and 50% in Gamma. If Example successfully establishes an $80,000 transfer price for marketing and administration services, compared with using the actual costs of $100,000 incurred by Alpha to provide those services, it will save $1,440.

THE WRONG INCENTIVE
The two most common approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.

For example, suppose Betas manager wants to improve profits, including the profits that result from transfer pricing. Suppose also that Example sets transfer prices at cost-plus-10%. Then what happens if excessive amounts of scrap and rework raise the actual cost by $1,000 for some output transferred from Beta to Alpha? The result of Betas inefficiency is that a larger profit will be reported for Beta, whose costs increase by only the $1,000 inefficiency, while the transfer price increases by $1,100. The net effect is a $100 increase in Betas reported income.

Using the market-based approach, assume a division producing the transferred goods and services also sells some of the same outputs to unaffiliated entities in arms-length transactions: Those transactions can serve as a starting point in a system of market-based transfer prices.

The latter approach not only avoids the incentive drawbacks of a cost-plus system but in theory it also is the preferred way to value the output of each unit. Its weakness is that its difficult to defend the system as being truly market-based. For example, a single item may have different prices in different markets, depending on local supply and demand, regulation, shipping costs and many other factors. Transfer prices must reasonably reflect those differences, and when market conditions change significantly, the transfer prices must be revised.

For the transfer pricing system to be defensible, it must be treated consistently throughout the company. So, for example, if credit risk is considered in one situation, it must be considered in others, too.

Another consideration: Because only a book entry at headquarters is necessary to recognize the payment and collection of a transfer price, the transfer is the equivalent of an immediate cash payment. This should result in an adjustment representing the time value of money. When great distances or national borders separate the different business units, a company must make several adjustments to arrive at defensible market-based transfer prices. The exhibit above is a summary of the adjustments used to arrive at a market-based transfer price.

The business must make a similar calculation for each category of item shipped to each location. For a large, vertically integrated company with dozens of locations and hundreds of products, this could entail thousands of calculations and frequent revisions.

ACCOUNTING AND REPORTING
Any transfer pricing system creates internal revenues and expenses recorded for the goods and services transferred between units. The company must eliminate them to calculate the overall entitys income. If transfer prices exist between only two units of a company, the recordkeeping may be simple. It must create a structure to justify the many eliminations needed when transfer pricing is used at multiple levels of a company, such as in Examples production of plastic parts at Beta, the use of plastic parts in making subassemblies at Gamma and the use of subassemblies in making telephones at Alpha.

As business gets more complex, the likelihood grows that your company will eventually have to deal with transfer pricing issues. Its prudent to understand the subject nownot when the taxing authorities are breathing down your neck.